Monday, September 27, 2010

“Better Lucky than Smart”: The Urban Legend of Warren Buffett

Asked by an audience member if returns such as those posted by Berkshire Hathaway Inc. Chief Executive Officer Warren Buffett…are the product of luck or talent, Taleb [Nassim Nicholas Taleb, author of “The Black Swan”] said both played a part.
If given a choice between investing with Buffett and billionaire investor George Soros, Taleb also said he would probably pick the latter.
“I am not saying Buffett isn’t as good as Soros,” he said. “I am saying that the probability Soros’s returns come from randomness is much smaller because he did almost everything: he bought currencies, he sold currencies, he did arbitrages. He made a lot more decisions. Buffett followed a strategy to buy companies that had a certain earnings profile, and it worked for him. There is a lot more luck involved in this strategy.”
—Bloomberg Businessweek, September 25, 2010

Far be it for we here at NotMakingThisUp to take on the author of “The Black Swan,” which is almost certainly the most timely cautionary thesis ever printed, warning as it did of the higher probability of random, dramatic, unforeseen, global cataclysms than most investors believed possible, just a year before the subprime mortgage crisis triggered a systemic risk of near-death proportions.
But Taleb’s comments, reported this week by the alliterively named “Bloomberg Businessweek,” during a speech in Montreal—comments that echo earlier statements by Taleb that “Soros has 2 million times more statistical evidence that his results are not chance than Buffett does,” whatever that actually means—deserve a quick look, if for no other reason than they are the stuff of urban legend. And it is a legend believed by more people than you might think.
Specifically, the urban legend surrounding Warren Buffett—about whom we took a very clear-eyed look in “ Secrets in Plain Sight: Business and Investing Secrets of Warren Buffett” (eBooks on Investing, 2011), including issues never before examined in the extensive literature on Buffett and his investment style—is that Warren Buffett was more lucky than smart.
It is a legend that comes up at least once every time we give a speech. Some skeptical guy (it’s always a guy: women love Buffett) who dislikes the personal politics of The Oracle of Omaha and is hoping to find a reason to believe his investment results are a sham, will be sitting there frowning, arms crossed, waiting for a chance to ask a question…and his question will always be along the lines of whether Buffett is really as smart as the masses make him out to be, and isn’t most of Buffett’s success owed to his luck at coming of age as an investor in the right place (America) at the right time (post-Great Depression), and where does Buffett get off going around lobbying for higher taxes anyway?
Now, Taleb has added a sort of statistical patina to the urban legend of Warren Buffett, by claiming that Buffett’s buy-and-hold investment strategy possesses a “randomness,” and that this randomness makes his returns suspect.
George Soros, on the other hand, “made a lot more decisions” than Buffett, according to Taleb (trading currencies as well as stocks, and also engaging in arbitrage), which would indicate that Soros’s returns are less random, and therefore more due to brains than luck; Buffett’s more random, and therefore more due to luck than brains.
The howler here, as anyone who has studied Buffett over the last few decades, is evident immediately, in the line about Buffett making “fewer decisions” in his career—the fallicay being, of course, the notion that buying (or shorting) something is the only act that involves a decision.
For if Warren Buffett has demonstrated anything, it is that deciding not to buy (or short) something is also a decision—and frequently a harder decision to make than writing a trade ticket and going along with the mood of the market.
Indeed, the reason Buffett left New York City for his native Omaha after working with Ben Graham in the 1950s was precisely the issue that, as he once put it, the closer to Wall Street an investor was situated, the more “stimuli” hit the investor, encouraging all sorts of decisions that were not necessarily productive or likely to be profitable. When asked why he moved back to Omaha, Buffett once said, simply, “It’s easier to think here.”
And that thinking led to extraordinary results—results that everyone accepts but few people actually grasp.

How good has Buffett been? Well, you can read the graphic facts for yourself in “Secrets in Plain Sight: Business and Investing Secrets of Warren Buffett,” but consider that the S&P 500 closed at 89.66 on the day Buffett took control of Berkshire Hathaway (May 10, 1965) and today stands at 1,148—a 13-fold increase excluding dividends
Meantime, a share of Berkshire Hathaway has risen from $18 that same day to $124,850—a 6,936-fold increase, and purely from price appreciation, since Berkshire doesn’t pay dividends.
As for Taleb’s charge that Soros is more facile than Buffett for using currencies and arbitrage in his bag of investment tricks (“he did everything”), this actually says more about Taleb’s spotty knowledge of Buffett’s investment history than it does of Soros’ abilities, great though they may be.
For not only has Buffett bought and sold currencies—his U.S. Dollar short early last decade was a money-maker for Berkshire, as was his long position in the Brazilian Real a few years back—but he has bought and sold commodities such as oil and silver, and frequently engaged in billion-dollar arbitrage deals such as RJR Nabisco. Indeed, Buffett once arbitraged a chocolate maker’s stock by selling cocoa beans on the open market, marking his first encounter with the Pritzker family, from whom decades later he purchased, lock-stock-and-barrel, an industrial business—something Soros has never done. So much for Buffett being a mere buy-and-hold equity investor.
Oh, and as far as shorting stocks goes, well, back in his hedge fund days (yes, Buffett ran a hedge fund before taking control of Berkshire) the Oracle of Omaha once borrowed and shorted the entire stock portfolio in Columbia University’s endowment.

The content contained in this blog represents only the opinions of Mr. Matthews, who also acts as an advisor: clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews’ recommendations. This commentary in no way constitutes investment advice, and should never be relied on in making an investment decision, ever. Also, this blog is not a solicitation of business: all inquiries will be ignored. The content herein is intended solely for the entertainment of the reader, and the author.

33 comments:

Warren Buffett is certainly a smarter than average man, but I have to agree with Taleb on this one. He was the recipient of quite a bit of luck. Shrewdness (related to brains) also played a part. As a former holder of Clayton Homes (bought out by Berkshire for a song) I know how managements were charmed into selling out to him for a pittance.

Taleb also ignores examples of Buffett making complex derivative bets etc. I also don't understand Taleb's logic. The "lucky fool" hypothesis is that many investors strike it rich though chance. Neither of these men probably qualifies for this label.

But if one investor finds something that works and consistently repeats this strategy, it seems rather silly to say that this person is more likely to owe his good fortune to luck. There's probably more certainty in this strategy (and it implies the investor knows his limits, which seems pretty wise to me).

It's also amusing considering Taleb's analogy of "when a coin is flipped 20 times and comes up heads every time, only an academic would say the odds are 50% that the next flip will be tails. The coin is probably fixed"

Let's also not forget that Buffett is allocating about $140 billion of equity capital + another $40-80 billion of intangible value depending on whom you talk to. This is a far more difficult task than allocating the $30-odd billion that Soros is managing.

I would take Buffett over Soros even managing 4-6x more capital. If they were both given $10 billion to start with, it's a no-brainer.

Wouldn't swear to it--it may not track the DJIA practice--but doesn't the S&P500 Index also de facto include dividends with its baseline assumption that dividends are reinvested to derive the Index Average?

Thinking that what Buffet did / does, and the success of it over a long period of time, can be attributed in any significant way to luck is really an extraordinary statement. Is such thinking the product of myopia, or an inexperienced person? Don't know, but I find it laughable.

Not saying that is what Taleb is saying, but it is what some of the commenters are saying. To Taleb I would say "it's not what you say, it's what they hear."

Apples to Oranges on the comparisons.To paraphrase Soros: "The most money I have made was identifying a trend I knew was wrong, riding it, and getting off before it ended". Soros is an amazing speculator, the perfect skill set for these frenetic markets. Buffet is a great fundamental investor, who has made much money for Berkshire in more recent years through trades on macro fundamentals or corporate distress (Level 3 Communications debt comes to mind) rather than long term investments.

Most of Soros's real profits came from a few big bets and it was not him alone either..

Basically, it was Jim Rogers who did most of the work the first ten years in the Quantum Fund and from about 1989 to 2000 (when almost all of the profits were made) it was Stan Druckenmiller who ran it.

Soros is also on record stating that if you exclude the "Black Wednesday" pound trade (which by the way was Druckenmiller's idea) and a couple of other big currency trades, he would have an overall net loss in currency speculation.

If luck was a determining factor for one of these guys, it clearly was for Soros.

The problem with Taleb is the fact that he doesn't seem to understand business.

Warren Buffett is first and foremost a businessman, not a pure trader/speculator or maybe gambler in the way Taleb understands it.

Taleb also criticised the authors of 'The Millionaire Next Door' in a way that indicated he didn't understand their point. He said that the millionaires in the book got that way as a result of investing in the stock markets during a time the markets went up. The authors of MND, on the other hand, said the millionaires got that way as a result of being cheap. Don't you know people who have gotten rich through being unwilling to spend money? Apparently Taleb doesn't.

Buffett's success prior to 1989 was in large part due to his skill at merger arbitrage. He lost money at it in '89, and gave it up then because Berkshire's size and the increased competitiveness of that business made it more difficult to make money. This business required changing the portfolio every few months.

Well, Soros returned 8% in 2008, while Buffett's Berkshire Hathaway was down 32%. To borrow one of Buffett's favorite sayings - it's only when 2008 ended that you learn who has been swimming naked.

It should be OBVIOUS that Soros is better than Buffett if all you want is absolute performance... and if you are a sophisticated investor, you want lots of absolute performance.

For the die hard Buffett worshipers, it must be hard to face the possibility that while Buffett is extremely smart, maybe he is not the smartest. Maybe people like Soros are smarter. Maybe lots of people are smarter than Buffett when it comes to investing.

The major difference between Buffett and most money managers is that he owns entire companies that generate enormous amounts of free cash flow which Buffett can allocate into other businesses. Money managers can't do that. The Berkshire model is itself a smart decision for which Taleb does give full recognition.

Great piece, I'd still bank on Buffett because he seems to have a sharp understanding of what he's doing. He discerns fundamental trends, keeps the management in checks and rides it out. He doesn't speculate, he's thoughtful and puts more effort in his relatively small number of deals than Soros does in his vast.

Also, I think we don't give Buffett enough credit, the man knows what he's doing and he does it consistently even when the chips are down.

Napoleon once said, If I'd had to choose between a great General and a Lucky General, I'd pick the lucky one every time.

So let me get this straight. According to Taleb if I make a dollar though some complex trades (derivatives, swaps, multi-currency trades) I'm smarter than if I make a dollar doing something "simple" like buying something low and selling it high? I think I'd vote for the guy that could deliver the most consistent results regardless of how it was achieved...

All of the above. He is both smart and lucky BUT he is more smart than FORTUNEate. Remove luck out of the equation and his decisions are so fundamentally sound that he will do just as well. I admire Mr. Buffett, luck or no luck he figured it all out!

Jeff, I want to respectfully dispute your point that there is any "urban legend surrounding Warren Buffett... that Warren Buffett was more lucky than smart." This is a straw man argument.

Other than Taleb's pot shot where does this urban legend lurk that says Buffett is lucky?

Did you hear it a Berkshire's annual meeting? Did some of the thousands who made the pilgrimage tell you they were there to see a lottery winner and not the Oracle?

A Google search on 'Warren Buffett is lucky' turns up this article as the wellspring of the meme.

And Taleb has said before, "I am not saying Buffett doesn’t have skill—I’m just saying we don’t have enough evidence to say Buffett isn’t doing it by chance."

Taleb's quip sounds like a backhanded put down. His Black Swan has been stuffed and made into a buttery intellectual Foie gras that gives him a license to serve up all forms of tut-tuting and pontificating. Nice work if you can get it.

I've followed Buffett for years and I haven't heard this "lucky" criticism. I have seen that his ethics have been called out on occasion, but not his acumen.

Didn't Buffett write the book on arbitrage plays in the 70's and 80's? He just got too big for it to make a difference. Taleb is just ignorant of the facts.

The number of decisions is what matters rather than which kind they were.

With 50 coin throws you have way more chance to success by chance than with sya a million.

Soros made very many individual trades, which makes his results much much more significant statistically than Buffet, who made overall quite little trades.

This does not have to do with how many *kinds* of trades he did, but rather with the absolute number of individual trades. (the diversity of strstegies has also a statistical meaning, but the number of trades is much more significant here)

JB asks where we hear this "lucky" stuff about Buffett. JB apparently didn't read the blog, which describes exacty where we hear it: pretty much everywhere we go.

Hayseed asks how close Berkshire came to a melt-down during the crisis. Aside from the fact the Berkshire CDS were blowing out as the insurance companies that had bought market puts from Berkshire bid up the price of making sure they'd get their money back, the answer is: not close at all.

As for Yechezkel Zilber's statement that "the number of decisions" matters more than what kind of decisions they are, well, statiscally significant that statment may be, he or she apparently does not invest for a living.

We'll take a couple of great decisions over a zillion bad ones any day.

Jeff, I apologize for doubting your evidence that this is widespread urban legend. I guess we both are not reading very well. Because you didn't directly answer my question of if you had heard this "lucky" criticism at the Berkshire annual meeting. But, you imply it was circulating there, because you've heard it everywhere. I'm just a little surprised people would spend serious time and money going to Omaha to hear someone they really consider lucky, especially since the meeting is so well covered these days.

As for whether this is a topic of conversation at the annual meeting, it kind of goes without saying that it is not something that the Berkshire investors who go to Omaha for the annual meeting don't think along those lines.

Buffet is not only a great Investor he is a great manager. Buffet's investment record may be beaten, but to match his amazing managerial record would be next to impossible. Tell me how many managers have built and managed a world class organization with just 20 people in the head quarters. I'm sure Soros Quantum fund would have more people in the back office than that. He has invested in almost everything; he wagered on Silver in 1998, Soros just happen to discover Gold.

And oh, this guy Tableb has successed in getting what he wants, if he has said the obvious nobody would have bothered to talk about it nor would he have got the people's attention. Any publicity is good publicity.

Interesting theory of Taleb. Putting it in another way: you aim and shoot 100 shots, and you hit, say, 90% of times - then you're just lucky. If you close your eyes and just shoot , and you hit, say 10'000 times, and you hit, say also, 90% of times - you're a good shooter. Statistically. Really? I do not buy it, anyway! :-/

Not sure if the Taleb quote is out of context, but if you read Taleb's Fooled By Randomness, there is a clear bias in favor of Soros and against Buffett (page 144). Could chalk this up to Nassim having met and liked Soros.

Wow, the vitriol against Buffet is interesting. It's comparing apples and oranges. But for the long-term investor, Buffet's Hathaway is clearly the choice. I don't think Buffet's decline in 2008 means anything, given the nature of his business. I lost less on a percentage basis than Berkshire but that means absolutely nothing--Buffett wins hands down over me. Where is he and his longterm investors now? In pretty good shape compared to virtually every investor.

This is not meant as a put-down of Soros. But the decision not to either buy or sell is a decision--not no decision as Taleb seems to infer--and Buffet's willingness to hold onto his cash/capital until he sees a reasonable return is what distinguishes him, I think. In fact, I try to emulate it by seeing 5-10 years as the only investment period that an investor like me can possible match against the Street. That has served me well the last 3-10 years, but reversion to the mean rears its head in a way that Buffett has absolutely destroyed. There is virtually no change Buffett's returns are chance and he would tell you, I think, that more of it is due to Munger than himself. That, in itself, is a a sign of Buffett's superiority. My 5c (if it's worth that much.)

Buffett's most amazing part is convincing everyone he is just a country yokel who invests in brand name stocks. He has crews of sophisticated investors making bets on his behalf. Soros and Buffett are really no different in they are very opportunistic and love "free money" when other investors are in weak positions.

Why bother Jeff? Every successful value investor has a moment where he/she thinks "Why doesn't everyone do this?" This sort of predictable diminution of Buffett's status is a wonderful phenomenon, and I wholeheartedly encourage it!

Buffett by far the best " hedge fund" manager ever! Most people only hear about his large equity holdings and think that is all he does. Options buying and selling, munis or distressed debt, currency plays, REITS, arbitrage, buying whole companies, and the most genius of all leverage from insurance float. Only thing holding back higher returns today is law of large numbers. Go back and look at upside downside capture of hedge fund days before BRK. He is smarter today than 40 years ago. Would be fun and amazing to to see what he could do today with 1 billion. i say 20-30% a year. The cons on Buffett probably think that Tiger won't ever win again too! BP

The golfer Gary PLayer once said, "the harder I work, the luckier I get."

I'm not sure I've ever agreed with Taleb, but definitely disagree this time. And, even if one is to buy the argument about Buffet not making many decisions, Soros only made about four big ones: Hire Rogers, listen to Rogers, hire Druckenmiller, listen to Druckenmiller.

'Buffett' posts a blog on Warren Buffett's "alpha" and asks if it makes sense to us.

First, saying that Warren Buffett's "alpha" (excess return above the market) has declined over time is like saying Derek Jeter is not the same hitter he was ten years ago.

The difference is that Jeter's deterioration is due to age, while Buffett's performance deterioration is due to the law of large numbers: it's hard to make money on large sums, and Buffett has been warning this would happen since (literally) the 1960s.

So, to that extent, the blog is stating the obvious.

Second, however, the decline in "alpha" (a term that would make Buffett vomit, by the way: why not just say "performance"?) seems exagerrated here, as the article claims Buffett's 10 year "alpha" was zero while in fact Berkshire's stock was up 100% in the last ten years while the S&P 500 is actually down.

So, net net, yes, in general, this article states the obvious. As we have written in these virtual pages, "This is not your father's Berkshire." Anybody expecting returns from BRK/A that are wildly in excess of the overall market will likely be disappointed.

On the other hand, they will not wake up any time soon and see their company disappear, like Bear Stearns, Lehman, Fannie Mae and the rest.

People tend to forget that George Soros spend 8 billion dollars the last 30 years. Even when the dollar was skyhigh against other currencies.

I think not attempting to be cynical but that this strategy is paying off the last couple of years if one sees the performance of his hedgefund. That's why right wing organisations are trying to ridicule or harass the master. He will be a lot more richer than other billionaires is my opinion, even if crashes or bullmarkets will explode. in % terms i mean it.